Incidental Personal Property

The regulations address the problem with a fifteen percent rule that is among the most frequently misdescribed provisions in the entire scheme. It is commonly presented as permission to include up to fifteen percent personal property in an exchange. It is nothing of the sort, and a practitioner who relies on that description will give wrong advice about what the rule protects.

17.1 What the rule actually does

The provision sits inside the safe harbor machinery, and its placement determines its meaning. The paragraph is titled "Items disregarded in applying safe harbors under paragraphs (g)(3) through (g)(5)," and its opening words state the question it answers.¹

In determining whether a safe harbor ceases to apply, and whether the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property are expressly limited as required, the taxpayer's receipt of or right to receive certain items "will be disregarded."²

Three categories are disregarded. Items a seller may receive as a consequence of disposition that are not included in the amount realized, such as prorated rents. Transactional items appearing under local standards as the responsibility of a buyer or seller in typical closing statements, the regulation instancing commissions, prorated taxes, recording or transfer taxes, and title company fees. And incidental personal property.³

The company the rule keeps is the interpretive key. Prorated rents and title company fees are not eligible for nonrecognition either. Nobody imagines the regulation makes a commission tax-free. These items are disregarded for one narrow purpose: so that their presence in the closing does not destroy the qualified intermediary arrangement.

The regulation states the tax consequence in the caption of the subparagraph itself, describing "personal property generally resulting in gain recognition under section 1031(b) that is incidental to real property acquired in an exchange."⁴ The personal property is boot. It produces recognized gain. The rule does not change that and does not purport to.

What the rule prevents is a different failure. Without it, a qualified intermediary holding funds that will be used to acquire a building together with its appliances might be treated as holding property outside the safe harbor, or the taxpayer's right to direct that acquisition might be treated as an unrestricted right to obtain the benefits of property. The exchange would then fail entirely, on constructive receipt grounds examined at Chapter 29, and the whole gain would be recognized rather than the sliver attributable to the refrigerators.

17.2 The two conditions

Personal property is incidental to real property acquired in an exchange if two conditions are both satisfied.⁵

First, in standard commercial transactions, the personal property is typically transferred together with the real property. This is a market-practice test rather than a valuation test, and it asks what ordinarily accompanies a sale of this kind of asset. Appliances with an apartment building satisfy it. Furniture, fixtures, and equipment with a hotel satisfy it. A seller's unrelated equipment stored in the building's basement does not.

Second, the aggregate fair market value of that property does not exceed fifteen percent of the aggregate fair market value of the replacement real property or properties received in the exchange.

Two features of the arithmetic are worth care.

The denominator is the replacement property, not the relinquished property, and it is aggregate across all replacement properties where more than one is received.

The measure is fair market value, not allocated purchase price and not book value. A contractual allocation is evidence but not conclusive, and an allocation adopted to fit under the threshold is precisely the kind of arrangement an examiner will test.

The Treasury made clear that the rule reaches beyond tangible items. It applies to non-real property regardless of whether that property is tangible or intangible.⁶

17.3 Not a safe harbor, and exceeding it is not fatal

Commenters asked Treasury to designate the provision a safe harbor. Treasury declined, and the preamble explains the consequence of exceeding fifteen percent in terms that practitioners should read directly.

Acquisitions of personal property valued in excess of fifteen percent of the replacement real property "are not disregarded in determining if one of the safe harbors in section 1.1031(k)-1(g)(3) through (5) ceases to apply," but they "will not automatically cause the exchange to fail section 1031 and the transfer of relinquished property to be treated as a sale or taxable exchange."⁷

The structure that emerges is a spectrum rather than a cliff.

Below fifteen percent, the personal property is disregarded in the safe harbor analysis. The intermediary arrangement is protected, and the personal property remains boot.

Above fifteen percent, the personal property is no longer disregarded. The safe harbor analysis must now take it into account, and the taxpayer must show on the actual facts that the arrangement satisfies the limitation on rights to receive, pledge, borrow, or obtain benefits. That showing may succeed or fail.

The consequence of failing is severe and disproportionate, which is why the threshold matters despite not being a bright line. A defective safe harbor does not merely tax the personal property. It exposes the entire exchange to constructive receipt, and the recognized gain becomes the gain on the real property as well.

The practical counsel follows from the asymmetry. The cost of staying under fifteen percent is that some equipment is bought outside the exchange. The cost of exceeding it is a fact-dependent argument about the intermediary arrangement with the whole deferral at stake. The trade is rarely close.

17.4 The rejected twenty percent proposal

Commenters also asked that the threshold be raised to twenty percent. The final regulations do not adopt those comments, and the stated reasoning illuminates what the rule is for.⁸

A limitation above fifteen percent, Treasury reasoned, "might induce taxpayers to bundle more personal property with their exchanged property," which "would lead to increased amounts of personal property exchanged with real property under section 1031 and effectively unlock a class of personal property that would no longer be 'incidental' to the real property."

The concern is with the word incidental. Congress removed personal property from section 1031 in 2017. A generous threshold would restore a measure of what Congress removed, by allowing personal property to travel with real property in quantities that make it a purpose of the transaction rather than an accompaniment. Fifteen percent was selected as the point at which personal property remains genuinely subordinate.

Reading the rule with that purpose in view resolves most application questions. The provision protects transactions that happen to include the ordinary contents of the asset being acquired. It does not accommodate transactions structured to move personal property.

17.5 Application and documentation

Four practical points close the chapter.

Identify and value the personal property before closing rather than after. The computation requires a fair market value for the personal property and for the replacement real property, and a valuation assembled during an examination three years later carries little weight.

Consider acquiring substantial personal property outside the exchange. Where furniture, fixtures, and equipment approach the threshold, a separate purchase funded outside the intermediary removes the question altogether. The personal property is taxable either way, so nothing is lost but simplicity.

Do not treat the fifteen percent as a target. It is a ceiling on a disregard rule, and there is no advantage to approaching it.

Remember the applicability date. The incidental property rule applies to exchanges beginning after December 2, 2020.⁹ Exchanges beginning between January 1, 2018 and that date fall into the interval addressed by the reliance rule at 14.1, and the analysis proceeds without this provision.

The computation of gain on the personal property, and its interaction with the netting rules, is developed at Chapter 33.